Friday, April 25, 2014

Maintaining Moats in times of Technological Changes

Over the past thirty years, we have witnessed unprecedented changes in technology. Some of the industries affected included newspapers, mail services, telecommunications and business forms processors.

In the pre-internet era, news were provided primarily through newspapers and television. The newspaper was published mostly once or twice per day, and included all of the information that someone would need for a given topic or their broad geographic location. The main revenue driver was the classified ads section, which provided essential information about jobs, services and special deals in the community. It provided an essential service by connecting buyers and sellers for goods and services in the area. Unfortunately, with the advent of the internet, news is quickly disseminated and available online in real-time. As a result, few people are actually willing to pay for news. In addition, sites such as Craigslist have managed to replace classified ads section in newspapers with their own bulletin board where interested parties can meet and exchange goods or services. This has eroded moats in the newspaper industry, and led to steep declines in profits. Previously, newspaper companies such as Gannett (GCI) and New York Times (NYT) were known for their long histories of raising distributions. The decline in newspaper profits and the financial crisis led to dividend cuts across the board. The only winners that have managed to somehow preserve their moat are specialized providers of information. A newspaper can still provide information online, but only to those who pay for it.

Mail services are another industry where the internet led to declines in profits. Fewer people send ordinary letters or greeting cards these days, as this has been replaced by email and egreetings. The US Postal Services has been slow to adapt to the new reality, has government mandates related to locations and store hours, and as a result has been losing billions. The one bright spot of the explosion in e-commerce have been packages. If you purchase a good online, you still need to have it delivered to you. This is where FedEx (FDX) and United Parcel Service (UPS) have been able to capture market share, and been able to grow profits. For companies like Pitney Bowes (PBI), which provides mail processing equipment and integrated mail solutions, the decline in importance of mail has affected bottom lines and has caused dividend payout ratio to rise to unsustainable levels and a dividend cut in 2013.

The world of telecommunications has been particularly affected by technology. Prior to the 1980’s split of AT&T, telecom was mostly a monopoly and earning utility like returns. After almost three decades of changes, fixed line services are a dying business, rendered obsolete by mobile phones. The telecom business is highly competitive, and it is pretty easy for a customer to switch carriers after their contract expires. There are a few fixed line telecom firms traded in the US, which pay very high yields and have dividend payout ratios exceeding 100%. These include Frontier (FTR) and Windstream (WIN). Given their declining distributions over time, I do not foresee anything else but dividend cuts. Time is certainly not an ally for a dying business like fixed line telephony. I am also highly skeptical of telecom firms like Verizon (VZ) and AT&T (T), since providing cell phone service is a commodity product that requires huge upfront investment and huge investments every few years or so, simply to keep up with competitors. All major cell phone carriers in the US carry similar phones these days, and have essentially similar customer experiences. Verizon and AT&T have mostly managed to earn a lot of money, because they managed to gather most of the subscribers through mergers and acquisitions. However this has happened at the expense of number three and number four carriers.

In addition, the business is characterized by the need for huge investments every few years or so, in order to maintain their status quo in the hot new technology of the day, whether it is LTE or 4G. I own a very small amount of Verizon, as a result of my investment in Vodafone (VOD) in early 2013. However, I doubt that dividends will grow fast enough to maintain the purchasing power of your income over the next 20 - 30 years.

As a result, the goal of the dividend investor is to focus on industries, which would benefit from technology, and whose moats would not be impacted. I highly doubt that technology would impact food companies like General Mills (GIS) or companies like PepsiCo (PEP). I also doubt that consumers who brush their teeth with Colgate-Palmolive (CL) products or those who shave every day using Procter & Gamble (PG) products like Gillette would impact the way these companies do business. On the contrary, technology could lead to more efficient supply chains, further reduction in inefficiencies, and further improving products to better fit the needs of customers.

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